SUMMARY
- Given the strength in bank fundamentals, preferred securities may offer opportunities to generate higher yield and higher return than traditional fixed income.
- PIMCO’s Preferred and Capital Securities Fund (PFINX) seeks attractive investment ideas in bank securities around the world, diversified across issuers, currencies and structures. We see opportunity for total return in many financials outside the U.S., especially in core European countries.
- We believe PFINX is positioned to perform well even if interest rates continue to rise.
- The fund provides diversification from both core bonds and equities, along with a relatively high source of income, some of which may be U.S. tax-advantaged.
With strong bank fundamentals – in the U.S., they are the strongest they’ve been in 50 years – preferred securities are among PIMCO’s highest-conviction corporate credit investments today. Preferred securities issued by U.S. banks have generally performed very well over the last year, and U.K. and European bank securities have performed even better given the cyclical recovery in European growth and improvement in business and consumer confidence. Over the next year, preferreds and similar securities issued by non-U.S. banks will likely continue to offer opportunities to generate higher yield and potentially higher return than traditional fixed income.
PIMCO’s Preferred and Capital Securities Fund focuses on the most attractive ideas we’re finding around the world, diversified across issuers, currencies and structures. In this discussion, Philippe Bodereau and Yuri Garbuzov, portfolio managers for Preferred and Capital Securities Fund, and Jeff Helsing, product strategist, review PIMCO’s approach and outlook for investing in global bank securities.
Q: Bank fundamentals are strong, and the strongest they’ve been in the U.S. in the past 50 years – what is driving this?
Bodereau: Following the global financial crisis in 2008, when governments and taxpayers bailed out several major banks while others failed, politicians and regulators around the world sought ways to prevent future crises. As a result of regulatory changes enacted over the years that followed, global banks now have two to eight times as much equity capital as they did in 2007, hold substantially more liquid assets on their balance sheets, and have reduced business volatility.
While regulation continues to evolve, one thing is clear: Relatively large banks are more fundamentally stable and resilient than they have been in decades. In our view, bank preferred securities, which benefit from these fundamental strengths across the financial sector, are an overlooked segment of the credit market. We seek to harness those strengths in Preferred and Capital Securities Fund (ticker PFINX for institutional class shares), in our efforts to offer investors attractive yield and return potential.
Q: What yield is PFINX offering investors today, and do you expect it will continue at that level?
Garbuzov: The fund’s distribution yield as of 31 March is 6.87% for the institutional share class (see Figure 1). Our base case estimate over the next 12 months is for similar market conditions.
As a reminder, the distribution yield tracks the average annualized distribution the portfolio has delivered over the past four quarters; it is calculated by dividing the annualized cash flows (dividends) by the price per share (net asset value or NAV) as of the latest distribution date. While we take income (distribution) into consideration, we manage the fund with a total return objective. In other words, we do anticipate turnover in the fund to generate attractive risk-adjusted return potential, which could boost the overall income to investors, but also create some fluctuations in the distribution.
Q: PIMCO Preferred and Capital Securities Fund – PFINX – recently reached its three-year anniversary. How has it performed over time?
Helsing: From its inception on 13 April 2015 through 30 April 2018, PIMCO Preferred and Capital Securities Fund returned 6.95% annualized (institutional shares, after fees – see Figure 2 for further performance information). The fund’s since-inception volatility of 5.01% as of 30 April 2018 is in line with the high yield market (proxied by the Bank of America Merrill Lynch High Yield BB/B Index) and about half the volatility of the S&P 500 over the same time period.
Over the three-year period through 30 April 2018, PFINX ranked #1 in the Morningstar Preferred Stock Category and outperformed the top 10 peers by 2.38 percentage points (see Figure 3). Importantly, after fees, PFINX has outperformed the largest five passive peers by 2.98 percentage points over the three-year period and by 5.50 percentage points over the one-year period, driven in our view by its active management approach and broader investable universe. At the end, we believe total return after fees, not just fees, is what counts.
Q: What matters most to taxable investors is after-tax income. Does PFINX offer potential tax advantages for U.S. investors?
Garbuzov: Yes, some of the fund’s distributions will be taxed at qualified dividend income (QDI) rates which, at roughly 20%, are considerably less than ordinary income tax rates (top federal rate of 37%). It’s worth noting that preferred stocks issued by U.S. companies and similar securities issued by non-U.S. institutions, like the Additional Tier 1 (AT1) (commonly referred to as contingent capital/contingent convertible/“coco”) securities issued by European and U.K. banks, all pay dividends. Essentially, for tax purposes, the payments individual investors receive on either non-U.S. AT1 or U.S. preferred securities are treated the same as a common stock dividend and taxed at dividend income rates, as long as holding period requirements are met. This means that for U.S. investors, preferred stocks may provide a compelling after-tax yield relative to other asset classes.
Q: Many investors are concerned about rising interest rates. How is PFINX positioned for a rising rate environment?
Garbuzov: The fund was resilient during interest rates spikes in late 2016 and in January 2018. One reason is that more attractive valuations helped us to cushion yields. But a key factor in the fund’s resilience to interest rate (i.e., duration) risk is that most of the portfolio holdings are structured as securities with fixed coupons for the first few years that later switch to floating rate coupons if not called. As a result, the fund doesn’t have much duration. This structure is typical in our experience for deals at the institutional level; most retail preferreds have much more interest rate sensitivity, with their coupons fixed for life.
Unlike a traditional fixed income security, preferred securities don’t have a maturity date when principal is due. If preferred securities weren’t callable by the issuer, they would likely be much more sensitive to interest rates. That said, preferred securities issued to institutions typically become floating rate securities if they are not called by the issuer after five or so years. These securities are often referred to as “fixed-to-float” or “institutional preferreds.” We believe PFINX is positioned to perform well should rates continue to rise, given strong bank fundamentals and the fund’s relatively low concentrations in fixed-for-life securities.
Q: How does PFINX fit into an investor’s broader portfolio?
Helsing: The Fund provides diversification from both core bonds and equities, along with a relatively high source of income, some of which may be U.S. tax-advantaged. Investors seeking a credit allocation with a lower sensitivity to interest rates than traditional corporate sectors, or investors looking to lower the risk in their equity market exposure without sacrificing potential return, may want to consider PFINX.
Investors have typically used the fund in three ways: as a substitute for high yield bonds or bank loans, given both relatively higher yields and low duration; as a substitute for convertible bonds, given equity-like return potential with historically lower volatility; or as a diversifier to core bonds, as the Fund’s correlation to U.S. Treasuries as of 30 April is negative.
Q: What strengths and capabilities should investors look for when choosing a preferred securities manager?
Bodereau: We believe global scope and scale are key in today’s preferred markets. U.S. bank fundamentals are near the peak and valuations on U.S. preferreds are close to fair on average (rich for many retail deals and more attractively priced for many institutional deals). We see more opportunity for total return in banks overseas. In Europe, for example, where economic recovery and the strengthening of the banking sector are a couple of years behind the U.S., we are seeing higher total return opportunities.
At PIMCO we have 16 investment professionals around the world, with decades of experience, all dedicated to analyzing and investing in global financial companies. PIMCO manages the largest actively managed bank capital mutual fund available in Europe or the U.S. I have been managing a dedicated Capital Securities strategy since 2011, and along with Yuri Garbuzov I have co-managed PFINX since its 2015 launch.
We believe PIMCO’s size and global resources confer several investment advantages: negotiating leverage with issuers, access to management of global banks, private and securitized specialists who provide insight on bank asset quality (including analysis of long-term sustainability factors), sovereign and political analysts, a deep bench of credit research analysts providing insights at the issuer and security level, legal expertise to help determine the balance of risk versus opportunity, and strong relationships with over 30 global counterparties.
With bank fundamentals at their strongest point in decades in some cases, now may be the time to partner with PIMCO in a preferred securities investment.
DISCLOSURES
This material is authorized for use only when preceded or accompanied by the current PIMCO Funds prospectus or summary prospectus, if available.
Past performance is not a guarantee or a reliable indicator of future results. The performance figures presented reflect the total return performance for Institutional Class shares (after fees) and reflect changes in share price and reinvestment of dividend and capital gain distributions. All periods longer than one year are annualized. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.
Investments made by a Fund and the results achieved by a Fund are not expected to be the same as those made by any other PIMCO-advised Fund, including those with a similar name, investment objective or policies. A new or smaller Fund’s performance may not represent how the Fund is expected to or may perform in the long-term. New Funds have limited operating histories for investors to evaluate and new and smaller Funds may not attract sufficient assets to achieve investment and trading efficiencies. A Fund may be forced to sell a comparatively large portion of its portfolio to meet significant shareholder redemptions for cash, or hold a comparatively large portion of its portfolio in cash due to significant share purchases for cash, in each case when the Fund otherwise would not seek to do so, which may adversely affect performance.
Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.
There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.
A word about risk:
Contingent Convertible (“Coco”) Bonds are bonds that are converted into equity of the issuing company if a pre-specified trigger occurs. Co-cos are subject to a different type of risk from traditional bonds and may result in a partial or total loss of value or may be converted into shares of the issuing company which may also have suffered a loss in value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.
Past rankings are no guarantee of future rankings. Fund rankings: 1Yr. 2 out of 56; 3Yrs. 1 out of 46. Morningstar Ranking for the Preferred Stock category as of 4/30/2018 for the Institutional Class Shares; other classes may have different performance characteristics. The Morningstar Rankings are calculated by Morningstar and are based on the total return performance, with distributions reinvested and operating expenses deducted. Morningstar does not take into account sales charges.
The benchmark is a blend of 70% ICE BofAML 8% Constrained Core West Preferred & Jr Subordinated Securities Index (P8JC) and 30% ICE BofAML Contingent Capital Index (COCO). The ICE BofAML 8% Constrained Core West Preferred & Jr Subordinated Securities Index tracks the performance of US dollar denominated high grade and high yield preferred securities and deeply subordinated corporate debt issued in the US domestic market. Qualifying securities must be rated at least B3, based on an average of Moody's, S&P and Fitch and have a country of risk of either the U.S. or a Western European country. Qualifying preferred securities must be issued as public securities or through a 144a filing, must have a fixed or floating dividend schedule and must have a minimum amount outstanding of $100 million. The ICE BofAML Contingent Capital Index tracks the performance of investment grade and below investment grade contingent capital debt publicly issued in the major domestic and eurobond markets. Qualifying securities must have a capital-dependent conversion feature and must be rated by either Moody's, S&P or Fitch. In addition, qualifying securities must have at least one month remaining term to final maturity and at least 18 months to maturity at point of issuance. For investment grade debt, qualifying currencies and their respective minimum size requirements (in local currency terms) are: AUD 100 million; CAD 100 million; EUR 250 million; JPY 20 billion; GBP 100 million; and USD 250 million. For below investment grade debt, minimum size requirements are CAD 100 million, EUR 100 million, GBP 50 million, or USD 100 million. It is not possible to invest directly in an unmanaged index.
PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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